Background

I am afraid that here will be increasing numbers of redundancies and job losses in the foreseeable future and the subject of lump sum termination payments and the pitfalls of not deducting income tax and/or Class 1 NIC is a difficult one. I want to be absolutely clear that it is wrong to assume that someone is automatically entitled to a tax free payment when they leave or lose their job. This is a mistake made by many employers.

The exemption and the pitfalls

For income tax purposes, there is a limit of £30,000, but only for payments that fall to be taxed under Section 401 ITEPA 2003. To come within s401 the payment must not be otherwise chargeable to tax and this is where HMRC starts asking a lot of questions; officers seeking first to establish if the payment is taxable as earnings under S62 ITEPA 2003, or as a restrictive covenant payment under S225 ITEPA 2003.

HMRC guidance at EIM 12850 indicates that taxable amounts within Section 62 include a payment received under the terms and conditions of service. HMRC will want to see the contract of employment, staff handbook or any letter or other documentation that will indicate whether there is a contractual entitlement to the payment to bring it within Section 62. In my experience too many employers fall foul of the desire to say “thank you and goodbye” when perhaps “cheerio and good luck” is enough. Careless words cost money. Paperwork that might indicate to HMRC that the payment was a termination bonus or payment for past present or future service should be avoided like the plague.

Garden leave payments, made when the employee is sent home instead of the employment being terminated are earnings within Section 62. PAYE and Class 1 NIC deductions should continue to be deducted in the normal way. Restrictive covenant payments, usually provided for in the contract of employment or a compromise agreement, are liable to income tax and Class 1 NIC under s225.

Payments in lieu of notice cause most problems, HMRC seeking income tax by virtue of Section 62 if the terms and conditions of employment are the source of the payment or if there is a custom or practice of making such payments.

Genuine compensation payments for loss of office or employment will come within S401, but HMRC will scrutinize such payments and may need some convincing that they are compensation, not earnings within Section 62. We may need to establish that the payment is rooted in the termination of the employment, as opposed to coming from the employment.

Statutory redundancy payments are exempt but at £330 per week will not exceed the £30,000 exemption limit. Non-statutory redundancy payments should fall within Section 401 and be exempt within the £30,000 limit, but HMRC will check that the payments are what they are called.

Taxable amounts

Payments of salary, bonus, commission, arrears of pay and holiday pay should be taxed in the normal way and Class 1 NICs should also be deducted, as should contractual payments in lieu of notice or any contractual compensation. If income tax is due and the payment is made before the employee leaves it should be included in gross pay and PAYE operated in the normal way. When a taxable payment is made after the employee has left and been given form P45, tax should be deducted at the basic rate. The employer should write to HMRC to advise of the amount and date of the lump sum payment and the amount of tax deducted. The employee should be provided with a copy of the lette

NIC

There is no equivalent exemption limit in the NIC regulations, which means that a payment is either fully liable as earnings or the payment is not liable if it outside the definition of earnings. This is irrespective of the amount paid. A payment is within S401 and exempt (up to £30,000) will not be earnings for Class 1 NIC purposes. HMRC guidance for Class 1 purposes is limited, but note what is said on “ex-gratia” payments to employees/directors on leaving a company:

“Be careful if a payment to a director of a small company is described as ‘ex-gratia’. If the director receives such a payment while in office, it is unlikely that you can accept the payment as anything other than earnings.

Before reaching any conclusion you must find out:

• the reason behind the payment
• what happened to the normal remuneration (salary, fees, bonuses)
• if the company is paying normal remuneration and, if not, why not
• why the company regard the payment as ex-gratia
• if only selected directors get these payments, why the others are treated differently.”

I have recently seen HMRC arguing that an ex-gratia payment is liable to income tax and Class 1 NICs because it has had its source in the employment. Be warned and ensure that there is documentation to support the argument that the payment stems from the termination, not from the employment.

Remember, you cannot assume that a termination payment is exempt. Check the facts and the documentation. There is no formal clearance procedure, apart from redundancy payments, so again be warned!