The current economic downturn is hitting businesses hard and many are having to consider making cost savings through redundancies and severances. This is never easy and can be made even more difficult by a complex set of tax rules. Many people have heard of “the £30,000 limit” and assume that any and all payments up to this level are tax free. This is not the case and termination payments incorrectly paid gross are “rich pickings” for HM Revenue & Customs’ (HMRC) enquiry teams.
Many packages offered by businesses are comprised of a number of different elements including statutory redundancy pay, payments in lieu of notice, compensatory payments, ex-gratia payments, amounts agreed through compromise agreements and restrictive covenants. All package elements can be taxed differently, so the first step is to break down the overall “package” into its component parts.
No matter what the circumstances are surrounding the employee’s departure, any payments relating to work previously carried out will be subject to both PAYE and National Insurance Contributions (NIC), including all outstanding payments of salary and bonuses. Additionally, any payments in respect of holidays not taken will also be taxable.
Statutory redundancy pay (up to a limit of £30,000) is not subject to tax or NIC. Tax will be due on amounts paid over that limit, but not NIC. However, care needs to be taken if the package includes other non-taxable elements as payments of statutory redundancy do count towards the £30,000 non-taxable limit.
Payments made to an employee “in return for something” will also be subject to tax and NIC. Typically, these include restrictive covenants prohibiting employees from revealing confidential information, working for a competitor or setting up in competition and agreements not to “poach” customers or staff.
Payments in lieu of notice can be taxable, but this will depend on the facts and the contract of employment. Where an employee is contractually entitled to a payment in lieu of notice, or where the employer reserves the right to make such a payment, then tax and NIC are due. Even if the contract is silent on the point, if it is the “usual practice” of the business to make such a payment then HMRC will argue that PAYE and NIC are due. This can only be established by looking at what has happened with previous terminations. Where it is accepted that the payment in lieu is not taxable then it will count towards the £30,000 exemption.
Ex-gratia and compensatory payments may qualify for the exemption, but the onus will always be on the business to demonstrate the circumstances leading up to the payment and how the eventual amount paid was decided upon. In contentious cases, businesses often enter into compromise agreements with departing employees. Advice from lawyers or in-house specialists might indicate that the employee potentially has a viable claim against the business and what amount could possibly be due in compensation. If the compensation relates to an alleged breach of contract by the business, then it will need to be apparent what that breach was. Typically this may be a failure to follow contractual redundancy procedures, unfair or constructive dismissal, or termination without notice (assuming that there is no clause or expectation requiring payment in lieu).
Where the departure is amicable and an ex-gratia payment is made, there would usually be a record (e.g. Board minutes etc) expanding on the reasons behind such a payment. These payments are often only made to long-serving employees where the relationship has progressed beyond the usual employer-employee basis. However, care must be taken to ensure that the payment is not seen as a reward for past services and, for employees aged over 50, that it is not an early retirement payment. The key to defending the tax-free status of an ex-gratia payment is always the contemporaneous paperwork. Without it, HMRC is likely to contend that tax and NIC should apply. As with all types of payment any excess over £30,000 will be taxable.
Any businesses considering making severance or compromise packages with employees would be well-advised to seek professional help at an early stage.
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