All change for taxing termination payments?

Posted 18/08/2016 By: Colin Makin

Termination payments on termination of employment, most often contained in settlement agreements, usually consist of 1) a compensation payment and 2) a payment in lieu of notice.How these payments are treated for income tax and National Insurance (NI) purposes is often the topic of much discussion between the parties.

The current position is:

Compensation payments:

Any such payments made in connection with the termination of employment will fall to be free of income tax or NI deductions up to £30,000.Any payment over £30,000 will be subject to deduction of income tax at the employee’s marginal rate but not National Insurance.

Payments in lieu of notice:

Where there is an express right under the contract of employment to make a payment in lieu of notice and the employer exercises that right then the payment will be subject to income tax and employers and employees NI contributions.

Where there is no such right but the payment is made as an automatic response to any notice period that is not worked, HMRC consider that in some cases it is arguable that the payment falls to be subject to tax and NI.

If there is no payment in lieu clause in the employment contract or, there is such a right but the employer chooses not to exercise that right, and there is no practice of automatic payment in lieu of notice, the payment will represent damages for breach of contract.Income tax and NI is not payable on damages for breach of the employment contract.

Clear as mud.

Government consultation:

The HMRC has issued a consultation document on draft legislation aimed at simplifying the tax and National Insurance treatment of termination payments and preventing manipulation of the rules.

The government is proposing that the £30,000 tax exemption for termination payments remains in place. There is no intention to increase the threshold.It is also proposed that any termination payment over £30,000 will be subject to payment of income tax and employers NI contributions but not employees NI contributions.

In respect of payments in lieu of notice, the intention is to treat all such payments (whether or not they arise under the contract or as damages) as earnings such that the payment will be subject to deduction of income tax and NI.

While the clarity is to be welcomed it will prevent employers from being able to pay employees a gross notice payment as damages in order to enhance a settlement deal.