Government consultation on the taxation of termination payments

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Government consultation on the taxation of termination payments

17 Aug 2015

The level of tax exemptions that employers and employees currently enjoy in termination payments could soon become a distant memory. With the aim of creating certainty by simplifying the system, the government have set out their proposals for reform of the current system in their consultation paper, Simplification of the Tax and National Insurance Treatment of Termination Payments, which was published on 24 July 2015.

Current System

The current system allows for a “tax-free threshold” on the following non-contractual termination and redundancy payments:

  1. Ex-gratia payments;
  2. Damages for wrongful dismissal (note that Payments in Lieu of Notice [PILONs], if contractual, are not included);
  3. Compensation for breaches of statutory rights, including unfair dismissal; and
  4. Payments of statutory and non-statutory redundancy.

This means that the first £30,000 is free from Income Tax and both employer and employee National Insurance Contributions (NIC). Whilst any amount in excess of £30,000 does become taxable as income, the payment as a whole remains free from employer and employee NICs.

The benefits to employers include the direct financial savings on employer NICs, as well as indirect financial savings based on the fact that settlement agreements and tribunal awards are generally negotiated on a net loss basis, which accurately reflects the employee’s losses. This means that ultimately it is more often than not HMRC that are left out of pocket on a termination payment, rather than the employer or employee.

What is the saving to the employer?

The gloomy reality is that without the £30,000 tax-free threshold, the cost to an employer to provide an employee with a £30,000 settlement sum (one-year net salary) would be £43,919.91 – an additional £13,919.91.

Government Proposals

The government is concerned that the current system causes confusion, particularly where termination payments are made up of many different elements. Central to this is the dilemma over PILONs, which will only be taxable if they are a contractual benefit for the employee. Even if non-contractual, the PILON is open to be challenged by HMRC if it can be seen as custom and practice to make PILONs.

Of particular note, the government is proposing:

  1. To remove the distinction between the tax and NIC treatment of contractual and non-contractual termination payments – this is hoped to remove the confusion caused by distinguishing between contractual and non-contractual termination payments such as PILONs;
  2. To align the tax and NIC treatment of termination payments so that they both become due at the same rate – this would mean that NICs will fall due on termination payments, and in doing so will start to accrue at the same time as when income tax becomes chargeable;
  3. To replace the tax-free threshold with a new exemption, where termination payment has been made in connection with a genuine redundancy situation as defined in statute. This will incorporate a new tax-free threshold, which is expected to be lower than £30,000 and will apply to employees employed continually for a minimum of two years, increasing proportionately up to a set cap.
  4. To introduce two new exemptions for payments that are not in connection with a genuine redundancy situation, but relate to a wrongful or unfair dismissal, and payments in cases of discrimination.

Whilst the government is not proposing to totally abolish the £30,000 tax-free threshold, the suggested reforms to the system will at least significantly reduce this figure and limit its scope. Employers will be dismayed if the threshold is set as low as the £6,000 base example in the consultation, which will rise by just £1,000 for each additional year service. The result of this may be that employers need to offer higher termination payments to compensate the employee, who would otherwise pick up the tax bill. The cost of settlement will be increased further by employer NIC liability, which will consequently be introduced.

Whereas the proposals do seek to iron out some imperfections in the existing system, it appears that the disadvantages may outweigh the advantages in that financial hardships to employees and small businesses may increase and any mitigated costs to the public purse caused by unemployment in the old system would be reduced.

Interested parties are invited to respond to the consultation by 16 October 2015. The consultation paper can be found here.

The Employment Team at Kuits will be providing a response to the consultations.  If you would like us to include your views in our response, please email Kevin McKenna: kevinmckenna@kuits.com.

For further information on this subject in general, please contact us or call the Kuits Employment Team on 0161 838 7806.

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