Government launches consultation on simplification of tax treatment of termination payments

One of the most contentious areas in the field of employment law concerns the tax treatment of settlement payments on the termination of employment. In the 20 years plus that I have been dealing with employment law matters the law in this area has never been entirely settled and there has been a long series of often contradictory decisions, such that it is possible to find a decision to match almost any chosen stance. As recently as two months ago I was writing about a decision of the First Tier Tax Tribunal which appeared to suggest that many such payments are not taxable.

Against this background, on 24 July the Government published a consultation document on “Simplification of the Tax and National Insurance Treatment of Termination Payments”. The consultation is open until 16 October and seeks views on:

removing the distinction between contractual (currently taxable) and non-contractual (currently generally non-taxable) termination payments and whether this will make the process easier to understand for employers and employees;
whether the income tax and National Insurance treatment of termination payments should be aligned;
which of the existing tax exemptions should be retained; and
whether new tax exemptions should be introduced.

Research by the Government suggests that there is a widespread but mistaken belief that the first £30,000 of any pay-off is tax free. Many employers do not understand how the current provisions should operate in practice. It is also difficult and time-consuming for employers to work out which parts of a settlement payment are tax free and which are subject to tax.

The research also suggested that the current £30,000 would probably be unaffordable if it applies to both contractual and non-contractual payments.

One potential approach referred to in the consultation is to create a new exemption which increases proportionately with the number of years worked. The minimum service requirement (to qualify for the exemption) would be two years. Qualifying service would have to be with the existing employer or continuing service including a former employer if the employee was TUPE transferred. Such exemptions might only apply in the event of redundancy, compulsory or voluntary. An example provided is that of an employee receiving a termination payment after 10 years’ service of £13,750 comprising statutory redundancy (£4750), pay in lieu of notice (£3000), an ex gratia payment of £5000 and £1000 holiday pay. If the exemption was set at £6000 after two years and then an extra £1000 for each additional year the exemption would be £14,000 and the entire payment would therefore be tax free. In contrast, if someone’s employment is terminated because of poor performance and that triggers a severance payment of £100,000, the full amount would be taxable.

termination payments: a trap for employers

A Ms. O’Farrell worked for Publicis Consultants UK Ltd. Her contract provided for three months’ notice.  She was made redundant in May 2009 and was provided with statutory redundancy pay and holiday pay. Her dismissal letter also said that she would receive an ex-gratia payment equivalent to three months’ salary (£20,625) free of Tax and NI deductions.